Fair Value Footnote Rule Is Step to Convergence

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Global accounting took another small step toward convergence today when the International Accounting Standards Board released its new rule on disclosures related to measuring financial instruments at fair value.

Known as IFRS 7, the new rule requires companies to disclose the level of liquidity risk associated with securities. To do that, companies using international financial reporting standards must describe the risk using the three-level hierarchy that was developed as part of FAS 157, the U.S. fair value measurement rule.

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The hierarchy outlines ways to value financial instruments depending on how liquid they are. Regularly traded securities are valued on their selling price (Level 1), whereas securities that are thinly traded or in illiquid markets have a different set of inputs (Level 3). In between are Level 2 inputs, designating securities being measured using estimates based on the value the company believes a hypothetical third party would pay for them.

In addition, IFRS 7 mandates that companies provide additional disclosures about the relative reliability of the inputs that go into the fair value measurements. For instance, in its financial statement footnotes, a company may want to disclose whether measurement inputs were based on prices collected from several brokers in an fairly active market, or based on one transaction in a stagnant market.

The changes to IFRS 7 are similar to the disclosure rules already in effect under U.S. generally accepted accounting principles, and apply to companies using IFRS for annual periods beginning on or after Jan. 1, 2009. However, IASB notes that companies are not required to provide comparative disclosures in the first year they apply the new rule.

The disclosure rules released today were in response to the recommendations made by the G20 to improve financial reporting transparency in the wake of the global credit crisis, and also reflected suggestions made by IASB’s Expert Advisory Panel regarding measuring and recognizing financial instruments when markets are no longer active.

In addition, IASB plans to publish an exposure draft, due out during the first half of the year, on fair value measurement that will address the definition of fair value and propose guidelines on how to measure fair value when standards require that methodology.

The disclosure rule and upcoming measurement draft represent just part of a larger fair value project to revamp IAS 39, the global rule on accounting for financial instruments. Many critics say that IAS 39 is too complex because it allows several measurement methods – fair value, historical cost, and a mixed model.

Other IAS 39 projects in the works will examine which financial instruments will be measured at fair value. In addition, IASB also expects to release an exposure draft on the derecognition provision of IAS 39 sometime this spring. That proposal will focuses on off-balance sheet assets and liabilities.